Redeye VC

Josh Kopelman

Managing Director of First Round Capital.

espite being coastally challenged (currently living in Philadelphia), Josh has been an active entrepreneur and investor in the Internet industry since its commercialization. In 1992, while he was a student at the Wharton School of the University of Pennsylvania, Josh co-founded Infonautics Corporation – an Internet information company. In 1996, Infonautics went public on the NASDAQ stock exchange.

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Shrink a Market!

On the First Round Capital website we write that: "We love investing in technologies and business models that are able to shrink existing markets. If your company can take $5 of revenue from a competitor for every $1 you earn – let's talk!"  I’ve often been asked what we mean by that – so I thought it would be a good topic for a blog post.
 

EncyclopediaMy first company, Infonautics, was an online reference and research company targeting students (mostly high school students). While I was there, I got a firsthand education on “asymmetrical competition.” In 1991, when we started Infonautics, the encyclopedia market was approximately a $1.2 Billion industry. The market leader was Britannica - with sales of approximately $650 Million, they were considered the gold standard of the encyclopedia market containing “over 44 million words” written by scholars and “more than 80 Nobel laureates”. World Book Encyclopedia was firmly ensconced in second place. Both Britannica and World Book sold hundreds of thousands of encyclopedia sets a year for over $1,000.
 

However, in 1993, the industry was permanently changed. That year Microsoft launched Encarta for $99. Encarta was initially nothing more than the poorly regarded Funk & Wagnall's Encyclopedia repackaged on a CD – but Microsoft recognized that changes in technology and production costs allowed them shift the competitive landscape. By 1996 Britannica’s sales had dropped to $325 million - about half their 1991 levels – and Britannica had laid off its famed door-to-door sales staff. And by 1996 the encyclopedia market had shrunk to less than $600M. In that year, Encarta’s US  sales were estimated at $100M.

So in just three years, leveraging a disruptive technology (CD-ROM), cost infrastructure (licensed content versus in-house editorial teams), distribution model (retail in computer stores versus a field sales force) and pricing model ($99 versus $1000), the encyclopedia market was cut in half.  More than half a billion dollars disappeared from the market.  Microsoft turned something that Britannica considered an asset (a door-to-door salesforce) into a liability. While Microsoft made $100M it shrunk the market by over $600M. For every dollar of revenue Microsoft made, it took away six dollars of revenue from their competitors. Every dollar of Microsoft’s gain caused an asymmetrical amount of pain in the marketplace. They made money by shrinking the market.

[It is also interesting to note how distruptive business models have continued to impact the encyclopedia market - anyone care to guess what Google and Wikipedia have done to Encarta sales in the last few years?]
 

5a_7At Half.com, we tried to do the same thing. We quickly learned that most readers of fiction books finished reading the book within two weeks after purchase. So we launched a very simple feature on our site. Say you purchased a John Grisham book from half.com for $15 (versus a market price of $30). Two and a half weeks later you would receive an email from Half.com offering “your money back” – users simply had to check a box and we would list their book for sale for $15. The vast majority of users would relist the book for sale -- and we found that for best selling books, we would sell the exact same copy of a book four times. That is, Buyer A would buy the book for $15, read it and sell it to Buyer B for $15, who would then read it and sell it to buyer C for $15, who would read it then sell it to Buyer D. Of course, we would take commissions from every sale – say $3 – and shipping charges – say $2 – from each sale. So for the four transactions, the out of pocket cost to the buyers would be $20. Now if half.com didn’t exist, you can assume that the books would have been purchased through traditional channels for $30 each – for a total out of pocket cost of $120. Think about it. For every $1 of sales on half.com, we took $6 away from the existing traditional channel - another example of  asymmetrical competition.
 

Free411This is the reason why I’m so excited about our recent investment in Jingle Networks. Jingle is the owner of 1-800-FREE411 – the country’s first nationwide provider of free directory assistance. Launched late last year, the 1-800-FREE411 service offers consumers a free alternative to the high cost of 411 service provided by traditional carriers. By including a ten-second advertisement before giving out a phone number, 1-800-FREE411 saves consumers on average $1.25 each time they look for a phone number from their telephone. Since American consumers use traditional 411 services 6 billion times a year, 1-800-FREE411 has the potential to shrink an $8 billion market. I believe (and hope) that as consumers shift to ad-supported directory assistance, we will take a significant share away from the entrenched carriers.

 

If you have a business that will shrink an existing market, allowing you to take $5 of revenue from a competitor for every $1 you earn, let’s talk!

 

For a great inside look at the creation of Encarta - I'd suggest "The Microsoft Way" by Randall Stross.  Just $0.75 on Half.com...

Comments

Jeremy Wright

Huh. I'd never thought of it that way, but I guess that's what our business (a blog media / network company) does to mainstream media. Lower production costs, faster publication, vaster distribution channels (thanks to RSS) and the ability to create free content (thanks to community involvement).

Interesting perspective. And, given the cost of traditional MSM advertising vs us, yeah, you could say that for every dollar we make we take away at least 5-7$ from the competition.

And, yes, we've been meaning to drop you guys an email. It's just that sometimes we get so caught up in the day to day running of the company that we forget about funding!

Mark

Hi Josh,

Interesting comments - do you really want companies that shrink a market, or companies that radically undercut competitors on price?

I ask because I don't think you list any reasons why shrinking a market is good; all the reasons you list are advantages of undercutting (through lower-cost manufacturing, marketing, and distribution).

The one reason I see to shrink a market is to become a monopoly in the resulting smaller market.

For instance, the market for auto repair business software had a half-dozen stodgy competitors in 1998 (I forget the market size but approximately $2 billion). None of them easily linked to the internet, a promising B2B tool for shops since they constantly call each other for parts.

Some friends and I co-founded a startup to create software that would manage shop inventory much better and enable B2B web commerce; our pricing plan was to give it away for free! Many auto shop owners are tech dinosaurs highly skeptical of newfangled software, so we sweetened the deal with no-upfront cost (typically thousands of dollars plus periodic upgrades); we would only charge transaction fees (a few dollars) on every customer invoice and B2B transaction.

We were in effect shrinking the auto repair software market, but only as an effect of undercutting on price. We were making a long-term investment to become a platform between shops. The resulting back-end integration and network effects of our software created huge barriers for competitors. We were happy to shrink the market from $2 billion to ~$500 million if we could take 80% of that pie with a highly defensible position.

But if you're not creating big barriers (which Encarta didn't), why shrink a market? Aren't VCs more interested in rapidly growing markets where several players can win, therefore increasing the chance that your startup can win?

Jeremy Wright

I'd argue that if you can shrink a market and capture a significant percentage, you'd likely also be able to completely redefine the market.

In Expedia's case, while Wikipedia and such are making text encyclopedias obsolete, they are able to delve more deeply into audio, video and user created content and communities (as well as licensing their content to a much broader base).

But, effectively, isn't most "disruption" based not only on a change but also on a price differentiator? If it isn't, most people who do business with incumbents won't deal with the newcomer precisely because it is so new and disruptive. But, show them a 50-80% savings and they'll take a bit of a bet ;-)

I'm not sure I buy that all undercutting will shrink a market, though. I'm doing a bit of work with Virgin America for precisely this reason.

BMC

In the Buy.com example, was your margin on a new sale more then the $3 made on reselling the same book? If so weren't you cannabalizing your own higher margin sales? Or did you test or have any data to support the fact that you'd significantly increase your initial conversions if a customer had the ability to resell their book after reading it? I'm just curious as to whether this was actually an incremental increase in revenue.

Nick

Just letting you know this article has made it to the most popular page on VCNewsCentral.com. Well done!

VCNewsCentral.com is a brand new blog & news aggregator, just like digg and reddit, but specifically for VC and Startup news.
VCNewsCentral lists postings from all the leading bloggers in the VC industry and then allows anyone to vote on the most interesting postings.

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Brian Breslin

Interesting perspective, I would bet that most people don't look at the figures that way, I know I hadn't. But it is basically factoring in your competitors lost revenue as a cost for them, and calculating that into your business plan.
It also makes sense, because how many startups come into a 2$bil market, and expect to take $1bil of it in sales in a few years? Whereas shooting for $100 mil of a now 1bil market is a much better goal (that and you theoretically have less costs than the entrenched existing competition).

Casual Visitor

Do you answer your email?

I actually responded to firstround.com with a ..believe it.. $T/yr project that meets the 'Shrink a Market' criteria, however you folks have seen no compuction to respond. What gives?

CV

CV

.

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The book form education industry is huge, and probably always will be. Well, I correct that - now with things like Kindle it will definitely take a new shape, but knowledge is an industry and its mandatory.

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Great post, Josh. It's precisely what Publish2 is planning to do to the Associated Press... http://blog.publish2.com/2010/05/24/the-new-associated-press-for-the-21st-century/

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